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CIAO DATE: 12/03
Social Security Reform Can't Wait
On The Issues
September 2001
The preliminary report of a presidential commission casts light on key failings of the Social Security system: The trust fund that supposedly supports Social Security is a sham, the system increases rather than decreases the uncertainty citizens face in planning for retirement, and contrary to common understanding and the claims of its more ardent defenders, it does not actually concentrate benefits among the poor.
The draft interim report of the president's Social Security commission was released on July 19. As one might expect from a document associated with Patrick Moynihan, the report displays significant intellectual heft. Economists have learned a lot about Social Security in recent years, and the commission presents the latest findings in an even-handed fashion.
While the commissioners have covered an enormous amount of material, their careful review establishes four key points that must be taken seriously.
First, defenders of the current system often argue that it is admittedly imperfect, but that it helps society achieve worthy redistributive goals. However, a number of recent studies, often conducted by left-leaning authors, have shown that far less redistribution exists than one might think.
Social Security looks highly redistributive at first glance because the benefit formula gives those with low incomes a high benefit relative to their contribution. For example, according to the latest Social Security Administration Trustees' report, an average worker earned $32,105 in 2001. When he retires, he will receive a benefit of $12,642, about 39 percent of his income. A low-income worker who earned about $14,500 in 2001 will receive about $7,600 upon retirement, about 53 percent of his income. That looks like a generous policy, but it turns out that a number of factors offset the apparent redistribution.
The most important is that low-income individuals have shorter life expectancies. An individual who dies at seventy receives half as many Social Security checks as a person who dies at seventy-five. Even if the checks themselves redistribute income, what matters is the lifetime benefit: The number of checks mailed is just as important as the size of the check.
In addition, Social Security has a spousal benefit that provides payments to spouses with no work history based on the earnings history of the one who did work. Some spouses receive benefits even though they never paid anything into the system. Poor people are much more likely to be single or divorced and not qualify for it.
Finally, benefits are not paid unless a worker qualifies by staying in the labor force for ten years. Spend eight years in the labor force, and you are out of luck. Low-income individuals are much more likely to be in that boat.
Put it all together, and redistribution is reduced tremendously. Is the reduction in redistribution so great that the program becomes regressive? That is the focus of the debate now.
A Financial Mess
The second key point is that the crisis is not really a long-run problem. Virtually everyone is aware that a financial train wreck is around the corner. However, reports of impending doom always seem to depend on extrapolations with horizons so distant that the precision of the calculation is questionable. How seriously should we take a seventy-five-year projection? The report does a great job of changing our focus. The problem is not that the Social Security system is in trouble if you look out far enough. We are now promising transfer payments that will be very difficult to pay. In present value, these payments significantly exceed revenues. Each year the financial hemorrhaging worsens.
If a business has $1 million in the bank but is losing $100,000 a year, the right policy is clearly to fix the problem now. It would be foolish to wait until the $1 million is gone to consider alternative business plans. The Social Security problem is the same.
To date, opponents of reform have preferred to run out the clock. If they continue to succeed, the long-run costs will be enormous. If we start raising taxes in 2016 in order to balance taxes and payments and then continue that policy thereafter, by 2030 a family with an income of $50,000 (in today's dollars) will face a $2,100 tax hike. If, instead, we choose to accomplish the same thing by cutting benefits, then a couple with an $18,945 annual benefit in 2030 will face a $4,605 benefit cut.
Third, it is crucial that we understand that accounting for uncertainty about the future changes everything. Understanding the impact of uncertainty on the Social Security debate has always been one of the greatest challenges facing economists. Much progress has been made lately, often because faster computers allow models to be more complex than ever. We now understand that uncertainty enters the debate through two channels.
Since the system is headed for a train wreck, there is a great deal of uncertainty about the level of benefits and taxes in the future. Ironically, Social Security was so named because it was intended to reduce uncertainty in peoples' lives. An insolvent system does the opposite. Social Security insolvency is probably the greatest retirement risk facing most Americans today. Americans have clearly caught on to this. A recent poll by Roper Starch Worldwide found that the proportion of individuals who are fairly sure they can count on Social Security as a source of income when they retire has dropped dramatically, from 88 percent in 1974 to around half today.
Since individuals generally try to avoid uncertainty, this suggests to me that the public's mistrust puts "free money" on the table. For example, if we offer individuals the option of receiving a payroll tax cut of 10 percent in exchange for lower retirement benefits of, say, 20 percent, my guess is that there will be many voluntary takers.
The discussion identifies the other way that uncertainty enters the picture. Myriad truly random factors affect the balance of our current system. Even if we adopted painful benefit cuts and tax increases today to put the system into balance, it is a virtual guarantee that Social Security would rapidly return to crisis. The system can remain in balance only if mortality, productivity, immigration, fertility, and countless other factors turn out just right. If somebody cures cancer-adding years to life expectancy-the system we fix today will be broken again.
The Trust Fund Scam
On June 18, Treasury Secretary Paul O'Neill told a group of financial executives in New York that the current Social Security system has no real assets. Since the Social Security trust fund is just an intergovernmental IOU-money that we owe ourselves-its presence is economically irrelevant. Democrats responded with outrage. Charles B. Rangel and Robert T. Matsui, for example, wrote O'Neill that they were "deeply disturbed by your remarks."
For the fourth point, the study lays out the case made by O'Neill quite carefully and cites other authorities-including the CBO, the GAO, and the Congressional Research Service-that have made the same point. If you owe your wife $10, it has no effect on your family's net worth. This discussion puts all the talk of lockboxes in the proper perspective. If owing ourselves $1 trillion has no effect on our ultimate ability to sustain Social Security, what good will owing $5 trillion do?
The commission's report shines bright light on our Social Security system, and the illuminated picture is not pretty. The system exists because its supporters think that it is highly redistributive, but it is not. It is buttressed by a trust fund that is a sham. It introduces needless uncertainty into people's lives. And even if we swallow the bitter medicine necessary to fix Social Security, the system will quickly break again thereafter.
Opponents of Social Security reform will undoubtedly use this report as an occasion to bash again the tax cut that was recently signed into law, but the tax cut is barely relevant. First, as the report highlights, Social Security is currently short about $12 trillion. That is about ten times the size of the tax cut. Second, any surpluses that did accrue in the absence of a cut would clearly be spent by pork-loving politicians. Finally, the capital reformation that results from lower tax rates is the only real preparation for future economic liabilities.
In 1934, President Franklin Roosevelt set up a commission, not unlike this one, and charged it with the task of evaluating the feasibility of a government program to provide retirement benefits to the elderly. While the commissioners were able men, they lacked the knowledge that modern economics has subsequently provided, and their product reflected that. The times were very different. This was, after all, five years before Pan American Airways initiated the first transatlantic air service. Our retirement system is about the only thing that has not been modernized since then. There are no reasonable arguments for further delay.
Kevin A. Hassett is a resident scholar at AEI.
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